Why I agree with (some of) Hayek

Friedrich Hayek is generally regarded as the apostle of a brand of economics which holds that the market will assure the optimal allocation of resources — as long as the government doesn’t interfere. It is a formalized and mathematical theory, whose two main pillars are the efficient market hypothesis and the theory of rational expectations.

This is usually called the Chicago School, and it dominates the teaching of economics in the United States. I call it market fundamentalism.

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I have an alternative interpretation — diametrically opposed to the efficient market hypothesis and rational expectations. It is built on the twin pillars of fallibility and reflexivity.

I firmly believe these principles are in accordance with Hayek’s ideas.

But we can’t both be right. If I am right, market fundamentalism is wrong. That means I must be able to show some inconsistency in Hayek’s ideas, which is what I propose to do.

Let’s start with Hayek’s influence on the twin pillars of my interpretation. I was a student at the London School of Economics in the late 1940s and read the great methodological controversy between Karl Popper and Hayek in Economica, the school’s periodical.

I considered myself a disciple of Popper. But here I was on Hayek’s side. He inveighed against what he called “scientism” — meaning the slavish imitation of Newtonian physics. Popper took the opposite position. He argued in favor of what he called the doctrine of the unity of science — that the same methods and criteria apply to all scientific disciplines.

I was drawn to this controversy by my interest in Popper. I had read his book, “Open Society and its Enemies,” in which he argued that the inconvertible truth is beyond the reach of the human intellect, and ideologies that claim to hold this truth are bound to be false. Therefore, he argued, they can be imposed on society only by repressive methods.

This helped me see the similarity between the Nazi and communist regimes. Having lived through both in Hungary, it made a great impression.

This led me to Popper’s theory of scientific method. Popper claimed that scientific theories can never be verified — they can only be falsified. So their validity is provisional — they must forever remain open to falsification by testing. This avoids all the problems of needing to prove scientific theories beyond any doubt and establishes the importance of testing. Only theories that can be falsified qualify as scientific.

While I was admiring the elegance of Popper’s theory, I was also studying elementary economics. I was struck by a contradiction between the theory of perfect competition, which postulated perfect knowledge, with Popper’s theory, which asserted that perfect knowledge was unattainable. The contradiction could be resolved by recognizing that economic theory cannot meet the standards of Newtonian physics.

That is why I sided with Hayek — who warned against the slavish imitation of natural science and took issue with Popper — who asserted the doctrine of unity of method.

Hayek argued that economic agents base their decisions on their interpretation of reality, not on reality — and the two are never the same.

That is what I call fallibility. Hayek also recognized that decisions based on an imperfect understanding of reality are bound to have unintended consequences. But Hayek and I drew diametrically opposed inferences from this insight.

Hayek used it to extol the virtues of the invisible hand of the marketplace, which was the unintended consequence of economic agents pursuing their self-interest. I used it to demonstrate the inherent instability of financial markets.